The illusion of safety
The holding whose number never falls is losing you money every year. The holding that falls one year in four is the one that gets you there. Part 1 explained why movement is expensive; this part is about what people do in response to it, which is usually worse than the movement was.
Guess before you read on
Money sitting in an account that pays nothing
Inflation runs at 3% a year. The balance never changes and never falls. How many years until that money buys half what it buys today?
Two things are called risk
One is how much the number jumps around. The other is the chance of not having what you need when you need it. They are not the same, and for long-term money they point in opposite directions.
Cash scores perfectly on the first. The balance never falls, no statement ever brings bad news, and the loss is total over a working lifetime. A broad stock holding scores badly on the first and is the one that gets people to retirement.
What cash actually does
The dashed line is the balance on your statement. The solid line is what that balance buys, measured in today's money.
Raise what the account pays until the two lines meet. At that rate your cash is just about holding its value. Now go and look up what your own account actually pays.
What mixing buys you
Two holdings that do not move together can be blended into something that moves less than either of them, without giving up any of the average return. The blended average is the weighted average of the two, exactly. The blended movement is less. Getting less of one thing and none less of the other is as close to free as this subject gets.
The lever that matters is the last one. It sets how closely the two move together, and at perfect lockstep mixing buys nothing at all.
Push the last slider to the far right and the benefit disappears. Two holdings that move identically are one holding.
The most expensive thing people do
A fall you hold through is a movement in a number. A fall you sell into is a loss, because you have turned a price into a realized amount and then been absent for whatever came next.
Below, one investor holds through everything. The other sells to cash after any year worse than the trigger, waits, and returns. Try several market numbers and count how often getting out helped.
This models an unusually well-organized panic. Our investor sells at the start of the next year, well after the bottom. They buy back on a fixed schedule, without waiting until it feels safe again. And they pay no tax and no trading costs. Every one of those four things goes worse in a real panic.
Seven problems
Estimate first, then check. An estimate within 25% counts.
Four situations you have not seen
Different setups from the ones above. Each turns on telling the two kinds of risk apart.
Write it down
Answers stay on this device. Nothing is graded and nothing is sent anywhere.
1. Where the money is
Think of money you or your family hold somewhere. Which of the two risks is it exposed to: the one where the number moves, or the one where the number holds still and buys less? Is that the right choice given when the money is needed?
2. Decide it today
Write down what you will do the next time something you own drops sharply in value. Do it today, while nothing is dropping. That is the exercise. When the fall comes you will not be in any state to think it through, and a rule you wrote calmly is the only thing you will have to hold on to.
3. The limit that matters to you
Read the fourth worked answer below, which lists what these models leave out. Which of those would matter most in your own situation?
Check yourself
Answer each one before revealing ours. If you read our answer first you will agree with it, which tells you nothing.
1. Two meanings of risk
Explain, without using the word "volatility", why cash and a stock index are each the riskier of the two depending on the question asked.
2. Why mixing works
Say why blending two holdings can reduce movement without reducing the average, and name the condition it depends on.
3. Sell low, buy high
Explain why "sell when it falls, buy back when it recovers" loses money even for someone who executes it perfectly.
4. Break the model
Name something these three panels leave out that would change what you should actually do.
Save or hand in your answers
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